Value Investing Strategies of Warren Buffett and Benjamin Graham

Archive for the 'Intrinsic Value' Category

Over the past 32 years, the per-share book value of Berkshire has grown from $19 to $19,011, at a rate of 23.8% compounded annually.

Due to the purchase of GEICO (becoming a wholly-owned subsidiary), there was a need to restate Berkshire’s 1995 financial statements.

From an economic point of view, the value of the 51% of GEICO owned at year-end 1995 increased significantly when the remaining 49% was bought.

This is because of major tax efficiencies and other benefits.

From an accounting point of view however, it was required for the value of the 51% to be written down at the time Berkshire went to 100%.

As a result, the original 51% of GEICO is now carried on the books at a value that is both lower than its market value at the time the remaining 49% was bought and also lower than the value at which that 49% is carried.

The Relationship of Intrinsic Value to Market Price

Over time, the total gains made by Berkshire shareholders should match the business gains of the company. When the market price temporarily overperforms or underperforms the business, some shareholders (buyers or sellers) will receive outsized benefits at the expense of those they trade with.

While the primary goal of Berkshire is to maximize the amount that their shareholders make, another goal is to minimize the benefits going to some shareholders at the expense of others.

In a public company, fairness prevails when market price and intrinsic value are in sync. This will never happen but a manager can do much to make them close.

The longer a shareholder holds his shares, the more his returns will match Berkshire’s business results; and the less it will depend on what his premium or discount to instrinsic value was when he bought it.

That is one reason Berkshire hopes to attract owners with long-term horizons.

Intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life.

It is not a simple value to calculate and must be estimated. This estimate will also depend on the interest rates and any forecasts of future cash flows. That is why Warren Buffett never gives an estimate of their own intrinsic value.

What is regularly reported is their per-share book value, which can be easily calculated but is of less use. This is because the book value of the companies that Berkshire controls may be far different from their intrinsic value.

For example in 1964, Berkshire’s per-share book value was $19.46. This far exceeded the company’s intrinsic value as all of the company’s resources were tied up in a non-performing textile business.

Now, the situation is reversed and Berkshire’s book value far understates their intrinsic value.

Nevertheless, the book value is still reported as it serves as a rough tracking measure for the intrinsic value. In any year, the percentage change in book value is reasonably close to that year’s change in intrinsic value.

As an analogy, consider a college educaion and think of the education’s cost as “book value”. The intrinsic value of the education is calculated by estimating the earnings of the graduate over his lifetime and subtracting from that figure an estimate of what he would have earned had he lacked his education. The final figure is then discounted back to present day figures using an appropriate interest rate.

Some graduates mya find that their book value of their education exceeds its intrinsic value and some may find otherwise. Whatever the case, it is clear that book value is meaningless as an indicator of intrinsic value.

On The Managing of Berkshire after Buffett’s Death

Warren and Charlie attend mainly to the task of capital allocation and leave all the running to the managers of the subsidiaries. Out of Berkshire’s 217,000 employees, only 19 of them are at headquarters.

The managers have total control over operating decisions and will dispatch any excess cash they generate to headquarters.

On Buffett’s death, none of his shares will have to be sold. They will be left to foundations who will receive them in installments over a dozen or so years.

The Buffett family will not be involved in managing the business but will help to pick and oversee the managers who do. Essentially, Warren Buffett’s job will be spilt into two parts. One executive who will be responsible for investments, and a CEO who will be in charge of operations. Any acquisition decisions will be mabe by the two with the approval of the board. These people have already been identified.

In 1996, Warren Buffett proposed having two classes of stock for Berkshire. A class “B” share will be created that has 1/30th of the rights of the existing (or “A”) shares but 1/200th of the voting rights.

In addition, class “B” shares will not be entitled to participate in Berkshire’s shareholder-designated charitable contributions program.

Everyone holding on to the class A share can convert it them into class B shares. This makes it easier for them to use Berkshire shares as gifts.

The motivation behind this exercise is the emergence of many (expense laden) unit trusts aggressively marketed as low priced clones of Berkshire.

Warren Buffett has the view that these Berkshire funds will be mass marketed with huge promises. The not so sophisticated buyers might be mislead by the potential of the funds.

It is likely that commissions and other expenses will eat into the performance, and these investors will be disappointed.

Through the creation of the class B shares, investors can invest directly into Berkshire.

The tradeoffs for Berkshire is that there will be additional costs associated with handling a greater number of shareholders.

A thing to take note for both current and prospective Berkshire shareholders is that the market price of Berkshire and the intrinsic value will not be the same all the time.

Ideally, they should be the same but in reality, there are times when the market value is higher than the intrinsic value and vice versa.

The more informed investors are, the smaller the gap between market value and intrinsic value. By creating class B shares, the merchandising efforts of the Berkshire unit trusts will be blunted and the market value of Berkshire will be closer to the intrinsic value.

When managers make capital allocation decisions, it is important that they act in ways that increase per-share intrinsic value and avoid things that decrease it.

For example, in considering business mergers and acquisitions, many managers tend to focus on whether the transaction would be immediately dilutive or anti-dilutive to earnings per share. This is insufficient.

Consider our previous example on college education. If a 25-year-old first year MBA student were to merge his future economic interests with that of a 25-year-old laborer, it would enhance his near-term earnings since he isn’t earning anything at the moment.

But such a deal would be downright silly for the MBA student.

Similarly in corporate transactions, it is important to look not just at the current earnings of the prospective acquiree, but to look at the effect on the intrinsic value of the acquiree.

Unfortunately, with the way many major acquisitions are done, they only serves to benefit the shareholders of the acquiree and increase the income of the acquirer’s management, but reduces the wealth of the acquirer’s shareholders.

A really good business will always end up generating more cash than it can use after its early years. While this money could be distributed to shareholders by way of dividends or share repurchases, often the CEO will engage some consultants or investment bankers for acquisition advice.

In Berkshire, the managers of the individual businesses will first look for ways that they can deploy their excess capital in their own businesses. The balance that is left will be sent to Warren Buffett and Charlie Munger, who will use those funds in ways that build per-share intrinsic value.

Warren Buffett considers intrinsic value as the only logical way to evaluate the relative attractiveness of investments and businesses. It is defined as the discounted value of cash that can taken out of a business during its remaining life.

This value is highly subjective as it depends on estimations of future cash flows and changing interest rates.

An example of college education is used by Warren to illustrate the possible divergence from book value and intrinsic value.

First, let’s treat the cost of education as it’s “book value”.

Then, we must estimate the earnings that will be earned by the graduate over his lifetime and subtract what he would have earned if he didn’t have his college education.

This excess earnings should then be discounted back to graduation day using an appropriate interest rate. The final value represents the intrinsic value of the college education.

Some graduates may calculate that the book value of their education exceeds the intrinsic value, which meant they overpaid. Other graduates may calculate and find the converse, which meant that capital was wisely deployed.

No matter what, it is clear that book value does not figure as a calculation for intrinsic value.

Now, let’s look at a real life Berkshire example.

Scott Fetzer was bought by Berkshire at the beginning of 1986 for $315.2 million, which at the time of purchase had $172.6 million of book value. A premium of $142.6 million was paid as Warren Buffett believed the intrinsic value of the company was close to 2 times the book value.

This premium would have to be written-off against earnings annually as shown in the table below:

Let’s look at these 3 terms which are discussed at the start of this letter.

Book value is just an accounting term that measures the capital (including retained earnings) that has been put into a business.

Intrinsic value is the present-value of the cash that can be taken out of the business during it’s remaining lifespan. As there is no way we can know the performance of a company in the future, therefore this value has to be estimated.

Market value is simply a price of the share of the company that is quoted on the stock exchange.

Intrinsic value is usually unrelated to book value. Berkshire is an exception and while the two values are different, the book value can be used as a device for tracking the progress of the intrinsic value.

In the long run, the market price and intrinsic value of a company will arrive at about the same price but in the short term, these two prices could be significantly different.

As an example, Berkshire’s book value and intrinsic value both grew by about 14% in 1993, while the market value grew by 39%.

Having said that, Warren Buffett still views Berkshire’s market price as appropriate if (a very big IF) they can continue to meet Berkshire’s long term goal of increasing their intrinsic value at an average annual rate of 15% (in a world of 6-7% long term interest rates). With an ever increasing capital base, this target is getting more and more difficult to meet.

When a company with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, repurchases of the shares by the company provide sure benefits to shareholders.

One benefit involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. Corporate acquisition seldom do as well.

Another less obvious benefit is that when management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, shareholders and potential shareholders usually increase their estimates of future returns from the business. This upward revision, produces market prices more in line with intrinsic business value.

Buffalo Evening News

A point that I managed to pick out was that the economics of a dominant newspaper are excellent, among the very best in the business world. Once dominant, the newspaper itself and not the marketplace determines just how good or how bad the paper will be. And either way, it will prosper. Do you have a dominant newspaper?

Errors in Loss Reserving (Insurance)

The determination of costs is a main problem in the insurance industry. Most of an insurer’s costs result from losses on claims, and many of the losses that should be charged against the current year’s revenue are exceptionally difficult to estimate.

In some cases, dishonest companies that would be out of business if they realistically appraised their loss costs have, in some cases, simply preferred to take an extraordinarily optimistic view about these yet-to-be-paid sums. Others have engaged in various transactions to hide true current loss costs.

In other businesses, insolvent companies will run out of cash. Insurance is different: you can be broke but flush. Since cash comes in at the start of an insurance policy and losses are paid much later, insolvent insurers don’t run out of cash until long after they have run out of net worth.

Washington Public Power Supply System (Bonds)

In the past year, there was a purchase of large quantities of Projects 1, 2, and 3 of Washington Public Power Supply System (“WPPSS”).

When Warren buys marketable stocks, he would apply the same criteria that he would use for the purchase of the entire business. This business-valuation approach applies even to bond purchases such as WPPSS.

The interest earned by the bond is treated as operating profits earned by the ‘business’. Such a valuation method means that he will never buy a bond giving a 1% yield! As Benjamin Graham quoted in his book “The Intelligent Investor”, Investment is most intelligent when it is most businesslike.

Dividend Policy

Even though allocation of capital is crucial to business and investment management, dividend policy is seldom explained. It’s often simply stated as a percentage of net earnings.

Inflation causes some or all of the reported earnings to become “restricted” – i.e. if the business is to retain its economic position, cannot be distributed as dividends.

For the rest of the unrestricted earnings, they can either be distributed or retained.

There should only be ONE reason for retention: Unrestricted earnings should be retained only when there is a reasonable prospect that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This means that returns are higher than market rate returns.

Many companies that show good returns both on equity and on overall incremental capital have employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, help to camouflage repeated failures in capital allocation elsewhere.

In Berkshire’s case, no dividend is given out for the simple reason that Warren can generate higher than market returns on those capital!

In the past year, there was an increase in the number of registered shareholders (due to the merger with Blue Chip Stamps) from 1900 to 2900. As such, Warren started this year’s letter with a summary of his key principles:

1) Shareholders are treated as owner-partners; Warren and Charlie Munger are simply managing partners. The company is simply a conduit through which shareholders own the assets of the business.

2) Company directors are all major shareholders of Berkshire Hathaway.

3) The long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. This is not measured by the size but more on per-share basis.

4) The preference for achieving point three above is by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. The second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by insurance subsidiaries.

6) Warren would rather prefer to purchase $2 of earnings that is not reportable under standard accounting principles than to purchase $1 of earnings that is reportable. Capital-allocation decisions are not influenced by accounting rules.

7) To prevent over-leverage, debt is seldom used.

8) A managerial “wish list” will not be filled at shareholder expense.

9) Common stock will be issued only when business value received is as much as the one given.

10) Regardless of price, Warren has no interest in selling any good businesses that Berkshire owns, and is very reluctant to sell sub-par businesses as long as he expects them to generate at least some cash and as long as he feels good about their managers and labor relations.

11) Investment ideas will normally not be discussed as good ideas are hard to come by.

Nebraska Furniture Mart

The letter goes on to highlight the main point of 1983; the acquisition of a majority interest in Nebraska Furniture Mart and the resulting association with Rose Blumkin and her family.

Rose started the business with $500 of her savings (after having arrived in USA with no money and no knowledge of English many years earlier) and grew it to over $100 million of sales annually out of one 200,000 square-foot store. One question that Warren always ask himself in appraising a business is how he would like, assuming he had ample capital and skilled personnel, to compete with it.

In his own words, “I’d rather wrestle grizzlies than compete with Mrs. B and her progeny.”

Book Value Vs Intrinsic Value

In the past year, the book value of Berkshire increased by 32%. Warren never takes the one-year figure very seriously. Why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Rather, a five year yard stick should be used.

While performance is usually reported in book value, the one that really counts is intrinsic business value. Book value only serves as a conservative but reasonably adequate proxy for growth in intrinsic business value.

Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

Using a simple analogy, assume you spend identical amount of money putting two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education.

Similarly, businesses having equal financial input may end up with wide variations in value.

Stock Splits

One of Warren goals is to have Berkshire Hathaway stock sell at a price rationally related to its intrinsic business value. The key to a rational stock price is rational shareholders, both current and future owners.

High quality shareholders can be attracted and maintained if there is consistent communication of the business and ownership philosophy – along with no other conflicting messages.

With a stock split or some other actions focusing on stock price rather than business value, an entering class of buyers inferior to the exiting class of sellers would be attracted.

Would a potential one-share purchaser be better off if the shares were split 100 for 1 so he could buy 100 shares?

Those who think so and who would buy the stock because of the split or in anticipation of one would definitely downgrade the quality of the present shareholder group.

Thus, Warren will avoid policies that attract buyers with a short-term focus on the stock price and try to follow policies that attract informed long-term investors focusing on business values.

Liquidity

Another thing that Warren frowns on is the emphasis on the liquidity of a stock by brokers. A high turnover in shares simply means that the ownership is changing. And the more of this ‘musical chairs’, the higher the commissions will be paid to the stock brokers out of the pockets of investors.

In my next post, I will cover economic and accounting goodwill that was discussed as an appendix to this year’s letter.

Operating Earnings
The percentage of operating earnings as a percentage of beginning equity capital dropped to only 9.8%. One reason was that for partially-owned (<20%), nonoperated businesses, accounting rules dictate that only the dividends received can be reported as earnings.

Even the earnings of 35% owned GEICO were not included. For accounting purposes, the company was treated as a less-than-20% holding as the voting rights had been assigned.

Thus, only the dividends received from GEICO in 1982 of $3.5 million after tax were included in the “accounting” earnings. An additional $23 million that represented Berkshire’s share of GEICO’s undistributed operating earnings for 1982 were totally excluded.

There’s accounting madness at work here. If GEICO had earned less money in 1982 but had paid an additional $1 million in dividends, reported earnings would have been larger despite the poorer business results. Conversely, if GEICO had earned an additional $100 million – and retained it all – reported earnings would have remained unchanged.

Warren prefers using a concept of “economic” earnings. This includes all undistributed earnings, regardless of ownership percentage. The point to bear in mind is that accounting numbers are the beginning, and not the end of business valuation.

To further highlight this point, Berkshire’s share of undistributed earnings from four of their major non-controlled holdings came to well over $40 million in 1982. This number, which is totally unreflected in the earnings report, is much higher than the total reported earnings of $14 million in dividends received from these companies.

The gigantic auction arena of the stock market continues to offer value investors opportunities to purchase fractional portions of businesses at bargain prices. This is possible as long as the market is moderately priced.

For the investor, an over-priced purchase of an excellent company can undo the effects of even a subsequent decade of favorable business developments. Value investors want the market to be cheap, not expensive!

Insurance Industry Conditions
The insurance industry continued to bleed. It is a good example of an industry with substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc).

If prices or costs can be controlled, the ‘bleeding’ can be stopped. This can be carried out legally through government intervention, illegally through collusion, or “extra-legally” through OPEC-style foreign cartelization.

Unfortunately, for the great majority of industries selling “commodity” products, a depressing equation of business economics prevails: persistent over-capacity without controlled prices (or costs). This results in poor profitability.

Over-capacity may eventually self-correct, either as capacity drops or demand expands. When they finally occur, there usually follows an enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment.

What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years.

The insurance industry operates under substantial overcapacity as it can be instantly created by capital and an underwriter’s willingness to sign his name.

Since there can be no surge in demand for insurance policies comparable to one in copper or aluminum, the only way for it to return to profitably is to reduce the supply.

Unfortunately, major sources of insurance capacity are unlikely to turn their backs on very large chunks of business, thereby sacrificing market share and industry significance. Major capacity withdrawals will require a shock factor such as a natural or financial “megadisaster”.

Issuance of Equity
In a merger, the first choice of the buying company is to use cash or debt to fund the purchase. In cases where these are insufficient, the issuance of new equity might be used.

When this happens, you will have to take notice. Why?

Companies often sell in the stock market below their intrinsic business value. But when a company wishes to sell out completely in a negotiated transaction, it usually can receive full business value in whatever kind of currency the value is to be delivered.

If cash or debt is to be used in payment, the seller’s calculation of value received is quite straightforward. If stock of the buyer is to be the currency, the seller’s calculation is still relatively easy: just figure the market value in cash of what is to be received in stock.

If the buyer’s stock is selling in the market at full intrinsic value, using it as currency for the purchase doesn’t pose any problems.

But suppose it is selling at only half intrinsic value. In that case, the buyer will be using a substantially undervalued currency to fund the purchase of a company at full intrinsic business value.

The issuance of shares to make an acquisition amounts to a partial sale of the business. Using it to fund an acquisition means that you sell it at whatever value the market happens to be granting it at that time.

And if the market price is under-valuing the business, you will have to scrutinize the deal carefully no matter what ‘reasons’ the managers might give you.

However, there are three ways to avoid destruction of value for old owners when shares are issued for acquisitions.

One is to have a true business-value-for-business-value merger, with each receiving just as much as it gives in terms of intrinsic business value.

The second route presents itself when the acquirer’s stock sells at or above its intrinsic business value. In that situation, the use of stock may actually enhance the wealth of the acquiring company’s owners.

The third solution is for the acquirer to go ahead with the acquisition, but then subsequently repurchase a quantity of shares equal to the number issued in the merger. This essentially converts it to a “cash for stock” purchase.

Another variable in mergers that is given too much attention is the effects of dilution on earnings. There have been plenty of non-dilutive mergers that were instantly value destroying for the acquirer. And some mergers that have diluted current and near-term earnings per share have in fact been value-enhancing.

What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value.

Finally, there is also a “double whammy” effect on the owners of the acquiring company when value-diluting stock issuances occur. A management that has a record of wealth-destruction through unintelligent share issuances will have a lower stock price for the company as the market accords a lower price/value ratio to them.